China may be headed for a hard landing

Agencies|

Jul 03, 2007, 01.29 AM IST

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SINGAPORE: Remind me again: Wasn’t 2007 supposed to be the year of soft landing for the Chinese economy? Halfway into the year, and after several rounds of monetary tightening, the reality is turning out to be just the opposite. Economists at the People’s Bank of China are now forecasting GDP to grow 10.8% in 2007. That will be the fastest pace of expansion in 12 years and almost 3% points higher than the 8% target announced in February.

And this is when we are discussing official figures. The economy may well be growing even faster. Surely this is alarming enough for policy makers to hit the brake pedals with all their might? The stock market’s nervous reaction to the latest economic forecasts seems to suggest such a concern. The CSI 300 Index fell 2.5% on June 29, posting its first monthly loss in almost a year. Jittery investors, holding on to overpriced Chinese stocks, are getting jumpy for the wrong reasons. The collapse, when it comes, will have nothing to do with the government’s efforts to contain the economy. It will most likely resemble the 19th- century American boom-busts when there was no US Federal Reserve managing the business cycle.

Investors have no reason to tighten their seat belts fearing central-bank action in China. It’s the lack of action that should make them fret. Monetary policy in China has fallen so far behind the curve that it’s probably too late to achieve a soft landing. This year, there have been two interest-rate increases. They have pushed up the benchmark one-year deposit rate by 54 basis points and made bank loans costlier by 45 basis points. There have also been five rounds of reduction in the amount of funds that banks have available for lending. None of this is helping with a surge in liquidity caused by a current-account surplus that the World Bank estimates at 11% of GDP this year. The undervalued yuan, which is fanning this surplus, is still not being addressed.

In the absence of meaningful appreciation in the currency, monetary tinkering will remain ineffective. The Chinese stock market, already a gigantic bubble, will keep growing. Based on price-to-earnings multiples, yuan- denominated shares in Shanghai are three times more expensive now than they were two years ago. Premier Wen Jiabao said last month that Chinese monetary policy needs “moderate tightening.” He’s probably basing his judgement on current inflation figures.

The same China Securities Journal report that revealed the central-bank researchers’ GDP forecast also said consumer prices will rise 3.2% this year. That’s hardly very different from the 3.4% annual pace at which prices rose in May. The last time the Chinese economy seriously overheated — from 1993 to 1995 — the annual average inflation rate was 15%, 24% and 17%, respectively. Of course, the Chinese people’s tolerance for inflation may be much lower now than it was in the mid-1990s. It’s possible that even a 4% annual increase in consumer prices will prompt people to take more money out of their savings deposits and invest in the stock market because banks are allowed to pay only 3.06% for a one-year deposit.

The recent decline in yuan-denominated demand deposits at banks suggests that such an incentive exists. Even then, the government is reluctant to put an end to this exaggerated risk-taking behaviour by raising deposit rates more aggressively than it has so far. Instead, it has decided to deal with it through fiscal — rather than monetary —measures. The official Xinhua news agency reported last week that lawmakers have approved a plan for China to cut or scrap its 20% withholding tax on interest payments from bank deposits. It is hardly a significant move. “A 50 to 60 basis-point increase in the net interest earned on deposits is far too small to change asset allocation behaviour in the marketplace,” Jonathan Anderson, a UBS economist in Hong Kong, wrote in a note to clients last week.

The threat from runaway money growth isn’t immediately obvious. M2 — cash and bank deposits — expanded almost 17% in May from a year earlier. That’s less than half the full-year figure for 1994. So there’s nothing to worry about, right? Look again at the data, focusing this time at just how much money there already is in relation to the size of the economy, rather than how fast it is growing in absolute terms. M2 in China is almost 37 trillion yuan ($4.9 trillion), or 1.77 times the nominal GDP, thanks to the money added in the process of the central bank’s purchase of US dollar inflows.

That compares with 0.97 in 1994. Policy makers in China can now only hope that this growth is benign, caused by rising demand for money rather than increased supply of it; because if it’s the other way round, it might be time to start preparing for a hard landing.